China's A2 Dairy Niche: Demand Side Paving Way for 3x Growth

A2 in China: Demand Paving Way for Major Growth

In a previous article “An In-depth Look at 7 Key Trends Shaping China's Dairy Sector: Part 1 Premiumization” I broke down the key attributes needed to harness premiumization trends in China’s dairy sector. I explained how diminishing returns in higher-value segments of dairy (e.g infant formula) prompt segmentation trends and a downstream cycle of rapid innovation, new product development and commercialization.

A2 Space Resistant to Commoditization Trends and USP Degradation

There is a race in China as major dairy stakeholders scramble to identify the next big trends and develop marketing USPs to unlock new growth. The a2 space is simultaneously an established USP (in the highest links dairy value chain - infant formula) and also one of China dairy's next major trends (for new segments like nutritional powders, FSMPs, UHT products, low-temp milk etc). Due to inherent supply-side constraints related to the time and investment needed to convert to correct genetics, farm and production segregation requirements, testing etc. the a2 space has been able to offset trends towards commoditization which we see damage the novelty/value of other USP trends which are adopted across the industry. This phenomenon invariably leads to market saturation, intense competition and ultimately culminates in the erosion of the "added-value" offered by the USP. In the a2 space, analysts are expecting an acceleration of the upward growth trajectory, with the most optimistic projections forecasting 300% growth in the next 3-5 years, putting the overall a2 dairy market in China on course for a multibillion-dollar valuation by 2025.

Premiumization Precedes Segmentation

In China’s dairy market, premiumization trends precede segmentation trends.?For the a2 segment champion, the A2 milk company (A2MC), its success was realized at the highest value links in the dairy value chain i.e. infant formula, where premiumization trends have massive influence over the sector. Here the A2MC's products and heavy investment in marketing and China-based clinical/nutritional research have acted as an incubator and driven overall consumer perception of a2 science and the perceived benefits of a2 products. This unprecedented success has attracted the interest of the other big dairy players and to a huge extent paved the way for these new entrants. Most of the D20 (China’s top 20 dairy companies) now have some stake in the a2 sector.

While the A2MC savvy use of trademarking has helped it avoid some competition in the infant formula space, (effectively confining many of its competitors to less-developed channels like cross-border e-commerce), these players have pivoted quickly to target other segments like premium UHT, fresh milk (pasteurized), nutritional powders for special dietary purposes (elderly, pregnancy nutrition etc) to drive further growth in the a2 space.?

As interest increases in China’s a2 dairy market and new entrants and capital influence the sector, competition is heating up fast. For the sectors champion, this is bad news with much of the low hanging fruit rapidly disappearing. This is compounded by massive disruption to the traditional daigou supply chains, growing geopolitical issues, which are translating to diminishing returns on the first-mover advantage which saw the company climb from a startup to an over billion-dollar valuation during the nascent phases of the Chinese a2 market.

Product development trends in A2

Infant formula

The success of the a2 sector has precipitated a flurry of new product development with most of the big multinationals entering the market and opting for an a2+ strategy which involves developing a2 dairy products combined with another key driver of premiumization like organic or fortifying products with high-value bioactive (breast milk mimetics like HMOs, immunomodulatory substances like Lactoferrin etc.).

This space includes Nestle (Wyeth nutrition) a2 Illuma range along and its less premium Nan a2 range, Bellamy’s Beta Genica-8 (a2+organic), Danone’s a2 Aptamil (a2 and organic and a2 and HMO fortified) along with its a2 Cow & Gate range. Big domestic players are also vying for the market with Yili Jinlingguan a2, Junlebao’s Zhizhen a2 and Mengniu’s Future Star.

A2 liquid milk

The UHT a2 space has come on quickly in recent years. Fresh low-temperature milk (pasteurized) has been growing strongly in China and big national players Bright and D20 giants with strong regional dominance like New Hope have all dipped their toes into this ultra-premium space to good effect.

Higher temperature processed products (UHT) are also experiencing strong growth. Unsurprisingly the A2MC has a strong position in this market. However domestic players, best exemplified by startups like Adopt a Cow and D20 heavyweight Modern Farming’s “Three Little Calves” are looking to usurp the current champion by utilizing ultralocalized, digital-heavy marketing strategies and blitzscaling -sacrificing early profitability for unfettered growth, revenue and rapid market penetration. ?(photo above utilizing premium pack Tetra Prisma 250ml and strong "evidence-based efficacy" - new food ingredient content/concentration claims on the label relating to GABA fortification supported by a serving suggestion to drink 30 minutes before bed and A2 content concentration content)

** Both companies have bypassed the genetic issues inherent in China's Holstein dominant gene pool which suffer from a relatively low frequency of the a2 allele and a lower prevalence of a2a2 homozygotes necessary to produce a2 milk. These companies have instead simply purchased and imported large numbers of animals and sexed semen directly from New Zealand, allowing the companies to bypass the need for animal identification, testing, segregation and breeding etc.

Interestingly both Adopt a Cow and Modern Farming have eschewed traditional bricks and mortar channels and instead focused almost solely on developing their own D2C e-commerce channels (tmall flagship stores etc.), livestreaming (Adopt a Cow and Viya – both Hangzhou based), proprietary apps, membership programs and curation of private domain traffic, official accounts, and we-shops, Douyin, Kuaishou etc. This strategy has propelled Adopt a Cow to dizzying heights, with the newcomer dominating sales during 11/11 to become the number 1 selling UHT milk during China’s monstrous digital shopping festival. This D2C focused e-commerce strategy allows new entrants to navigate China's challenging dairy retail and distribution value chain and retain a more competitive bottom line by avoiding the gauntlet of middlemen, financially onerous listing fees, sales commissions etc.

Premium ingredients and midtier pricing: Commoditization is inevitable but not in the short term due to supply-side constraints. Liquid A2 Milk Set for Growth

Conversion to a2 takes time and money. Larger established organizations have suffered from decision inertia fence-sitting or waiting to see if the a2 hype train derails. Things are changing though and the biggest global players like Nestle are now investing heavily in a2 research and downstream product development.

According to the "2021-2027 World and China A2 Milk Market Research Report" released by Chenyu Information Consulting Market Research Company, the a2 liquid milk market reached 6.8 billion yuan in 2020 and is expected to reach 13 billion yuan by 2026 at a CAGR of 9.7%. ?

As the a2 market in China moves from a new commercial concept to an established value-add we are seeing increased investment in the sector from both startups and established players. With segmentation driving new product development we are seeing an increasing variety of products across various niches (ambient milk, yoghurts, nutritional powders, meal replacements etc.) Unsurprisingly the increased investment has seen an overall increase in supply as farmers convert herds or in China’s case, it simply imports large amounts of a2 genetics. In the a2 liquid milk space, two races are being contested simultaneously.

Striking the Balance: Value-add vs value for money

There is a race to the top in terms of premiumization and delivering a top-quality product that ticks all the premium boxes (provenance, branding, packaging, milk source, ingredients). The other race is one to the bottom and delivery of the best value for money to consumers. With economic concerns and inflation tightening the purse strings of consumers striking the correct balance between value-add and value for money is increasingly tricky. Importantly for new entrants, it is vital when utilising insights on consumer behaviours to drive NPD that equal attention is paid to understanding the practicalities and demands of China's value chain.

Domestic A2 Liquid Milk Products (Pasteurized and UHT)

Imported A2 Liquid Milks Sold in China

Horizon Scanning: Regulation Inevitable

Currently, there are no specific vertical standards that specify the requirements for a2 dairy products in China. Instead, there is a loose framework of horizontal standards which specify the labelling requirements for all foods and a2 requirements are encompassed within. The non-specific a2 regulatory framework begins with China's Food Safety Law and is incrementally detailed by subordinate legislation, regulations, standards etc. The most relevant standard is GB 7718 - China's General Standard For Labeling of Prepackaged Foods which broadly specifies the requirements for content labelling (non-nutrient, non-functional content labelling) of foods.

Articulated within this standard are the requirements which underpin the labelling of a2 products in China, particularly the a2 concentration (w/v) labelling we see used by domestic companies. Vertical standards for infant formula (GB 1076x series), liquid milk (GB 25190) etc also include specific requirements for each product but there are no a2 specific provisions. Given China's strict regulation of all functional claims, companies have not yet looked towards the health claim route in regards to a2 dairy products and its success in China has been driven by word of mouth, promotion of scientific data and soft marketing claims. Finally, there are specific testing requirements that together form a de facto customs clearance dossier which will be inspected by customs clearance officials in China's ports.

Plotting the Trajectory of Future Regulations

There are no specific regulations in the pipeline for a2 dairy in China, however, it's my assertion that as the market hots up it is inevitable that regulations will be developed as we have seen in other high-value niches important to value-add dairy. China has a long track record of utilizing technical barriers to trade to shape market forces and as the economic importance of a2 increases so too will the need to control the market.

With the big D20 players investing heavily in a2 and with consumer awareness around a2 expanding rapidly we can expect 1 of 2 things:

• 1) The leading industry players will develop internal enterprise standards that will in time become an industry best practice, shape market forces and form a foundation for the development of downstream national standards
• 2) Alternatively the d20 players (particularly the state-owned players like Bright) will work in collaboration with policymakers or ministries like SAMR to develop a new national standard.

The national standard development cycle usually involves a foreshadowing phase in which government outline a broad goal, policy and principles and task competent authorities to realize their vision. Depending on the importance of the planned changes the forum for expounding these goals can change, with issues of national importance being dealt with at a State Council level and smaller issues handled during conferences etc by Ministries or subdepartments.

In terms of food regulation, planned changes to national standards are listed in the food standardization agenda for the year. Finally, a draft document is released for public consultation, which usually lasts for several months. Depending on feedback there can be a second draft issued or alternatively the new standard is implemented and depending on the level of impact on the industry there is usually a grace period offered (usually a year). Given this fairly standard process, I would expect no change to current working requirements in within the next 3 years.

In terms of how regulation is developed and what that regulation looks like, I think the compliance demand on the industry will be carefully titrated to the level of economic importance given to the a2 sector at that time. If the a2 market doesn't realize its strong potential I imagine any future regulation will simply involve some minimum a2 concentration and quantification requirements. If the economic potential of the market is realized I could envisage more demanding requirements in the form of herd testing accreditation, supply chain inspection steps at multiple checkpoints, onsite inspection to ensure sufficient production line segregation (to ensure no a1/a2 cross-contamination) and potentially more generic requirements based on a modified standard manufacturer registration.